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Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside
Pavel Kaganas [email protected]
1
Investment Thesis
Kone is a short. Asia was 85% of Kone’s growth in the last 5 years and now represents 40% of the business.
However China experienced a 13% decline in starts so far in 2014 (and 8% decline in footage sold), and will
continue to decline on excess housing inventory and more wealth moving abroad.
China is also getting more competitive, with 8 large global and local elevator players compared to 4 major comps in
the RoW. Limited China capacity has supported pricing and margins in recent years, but every competitor has now
over-built capacity (~700k units vs. ~500k of sustainable demand). This is pressuring prices, squeezing margins, and
will only get worse with China’s wage escalation. The leading competitor with best execution (Otis) is also winning
back China share, as it was un-blackballed following a deadly accident several years ago.
Much of the street believes Kone’s guidance that Chinese volumes will continue to grow from 2012/13’s excessive
base. This is reflected in the consensus target of €1.82 EPS in 2016 compared to a more likely estimate of ~€1.28.
The shares are also priced to perfection at 21x trailing and 20x 2014 PE, requiring uninterrupted growth for share
appreciation. The weak European business, rich valuation and cheap carry limit near-term risk for a short, while
Chinese lead times catching up into order declines offer an attractive ~40% upside potential at a €20 target. Risks
are timing (orders/backlog still growing) and potential China stimulus.
Kone Oyj - Summary Financials Consensus
(€mm) 2008 2009 2010 2011 2012 2013 Jun-14 2014E 2015E 2016E
Total Revenue 4,603 4,744 4,987 5,225 6,277 6,933 7,063 7,389 7,895 8,348
Growth 12.8% 3.1% 5.1% 4.8% 20.1% 10.4% 6.2% 4.6% 6.8% 5.7%
EBITDA 623 665 762 791 906 1,023 1,065 1,124 1,217 1,303
Margin % 13.5% 14.0% 15.3% 15.1% 14.4% 14.8% 15.1% 15.2% 15.4% 15.6%
Backlog 3,577 3,309 3,597 4,348 5,050 5,588 6,537
YoY Growth 9.0% (7.5%) 8.7% 20.9% 16.1% 10.7% 11.3%
Diluted EPS 0.83 0.92 1.05 1.26 1.29 1.44 1.51 1.55 1.69 1.82
Growth na 10.9% 14.2% 20.1% 2.6% 12.1% na 7.5% 9.1% 7.5%
Capitalization Valuation Multiples Consensus
2013 Jun-14 2014 2015 2016
Share Price € 31.69 TEV/Rev. 2.2x 2.2x 2.1x 2.0x 1.9x
Shares Out. 513 TEV/EBITDA 15.1x 14.5x 13.8x 12.7x 11.9x
Market Cap. € 16,271 P/Dil. EPS 22.0x 20.9x 20.4x 18.7x 17.4x
- Cash 926
+ Total Debt 133
TEV € 15,478
5-yr trading history:
Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside
Pavel Kaganas [email protected]
2
Key Investment Points
Priced for growth; all growth tied to softening China construction market:
Kone’s revenue CAGR’d at 9% from ’08-’13, but Asia accounted for 85% of that growth. Kone’s 30% APAC
CAGR outpaced even China’s booming Elevator & Escalator (E&E) market CAGR of 20%, to become the #1
E&E producer. APAC now accounts for 40% of revenue, compared to 15% in 2008, and makes Kone the
most China-leveraged of any major E&E player. They are also the most leveraged to China’s residential market
(60% of revenue), half of which is gov’t-supported affordable housing; a market the company admits will not
grow this year. Even China’s manipulated “official” property starts were down 13% YTD July, with
tough comps ahead from China’s excessive construction spike in mid-late 2013 (real declines in starts may be
even worse). Inventories are at two-year highs (exhibits in appendix), especially in the lower-tier cities which
had the fastest growth in recent years. The continued shift of Chinese investments abroad further pressures
property markets.
Intense/ifying competition and over-capacity will pressure margins:
Kone’s (and most of the E&E industry) revenue and profit growth were not impeded by the recession of
‘08/09 thanks to China. They continued to perform well enough through 2013, but with tougher pricing,
pressured margins and slowing markets. Maintenance margins and market share have been resilient longer-term
but swing more through downturns, as happened in the US and Europe through ’09-10 and even now in
Southern Europe. China pricing is also pressured (not outpacing ~10% wage escalation.)
The industry’s assembly-focused operations (outsourced components) create a mostly variable cost structure,
giving little operating leverage through growth, and eliminating any lasting benefits of winning market-share at
the cost of near-term margins. That margin is gone and market share will flip right back once the low-end prices
back up (best operators like Otis don’t price down much). Kone also admits that most supply chain
globalization benefits have already been realized. There is no margin upside here.
China’s relatively nascent E&E market (90+% new equipment vs. 20-40% RoW) combines more lower-end
units with minimal maintenance work (~65% of global units but only 30-40% of global revenue; 30+% lower
ASPs.) This provides no downside cushion, so revenue is completely reliant on volatile construction volumes.
Further, New Equipment (NE) margins in China have been higher than the RoW and 2013 was a record year
for China construction. This means any flattening or declining equipment orders will soon hit Kone’s top-line,
and even harder on earnings (12-month order-to-deliver lead times).
Hard Comp; Slow Start
Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside
Pavel Kaganas [email protected]
3
The “Big 4” of Otis, Kone, Schindler and Thyssen dominate the EMEA and US markets, and have selectively
increased capacity in those markets. But they have expanded much more in China, where the large Japanese and
smaller Chinese competitors are also adding tremendous capacity. While limited capacity in China supported
prices and margins in recent years, intensifying competition and margin contractions has already started, and
will only intensify. The increased capacity signals strategic intentions and will shape the looming war for market
share.
Legacy
businesses
slowing/shrinking
The ex-Asia market relies more on recurring maintenance work, which accounts for 60-80% of EMEA and
Americas revenue, over 60% of Kone’s EBIT, and carries double the margin of NE. The China slowdown and
aggressive capacity expansions, will force increasing competition into these legacy markets and squeeze margins.
Kone has cited price declines in Europe for over a year and its ex-Asia business was flat so far in 2014.
The biggest factor to be felt across all segments is the slowed backlog growth. There is little reason to envision
much backlog improvement, as orders catch up to China starts declines (lag in residential from “start” to E&E
order), as does Europe. The Americas are too small to offset the balance.
(2%)
(1%)
0%
1%
2%
3%
€ 2,700
€ 2,800
€ 2,900
€ 3,000
€ 3,100
€ 3,200
Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14
EMEA - LTM Revenue and Growth
(5.0%)
(2.5%)
0%
2.5%
5.0%
7.5%
10.0%
€ 850
€ 900
€ 950
€ 1,000
€ 1,050
€ 1,100
€ 1,150
Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14
Americas - LTM Revenue and Growth
0%
3%
6%
9%
12%
15%
18%
€ 0
€ 500
€ 1,000
€ 1,500
€ 2,000
€ 2,500
€ 3,000
Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14
APAC - LTM Revenue and Growth
(15%)
0%
15%
30%
45%
€ 3,000
€ 4,000
€ 5,000
€ 6,000
€ 7,000
Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Dec-12 Jun-13 Dec-13 Jun-14
Total Kone - Backlog and Growth
Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside
Pavel Kaganas [email protected]
4
Company Overview
Based in Finland, Kone OYJ is one of the largest global elevator manufacturers, holding #1/#2 positions in EMEA
and Asia. 45% of revenue comes from higher-margin recurring Service revenue and 55% from NE. This flipped
from 53/47 several years ago, as Kone was an early mover (following Otis) in China’s NE construction boom
(APAC is 40% of revenue, compared to 15% a few years ago). Kone is heavily leveraged to China’s residential
market, generating ~60% of its revenue. The Company has also been aggressively acquiring maintenance operators
outside of China, completing up to 30 small acquisitions per year; €650mm of M&A over the past 7 years. The rest
of FCF is paid out through dividends.
Industry and Competition
The E&E industry is very mature, generating healthy margins and excellent returns on capital. Except for a minor
ex-Asia pullback during the financial crisis, and largely driven by Asia growth, it has outgrown most global macro
and construction trends. Though Europe dominates the installed base for maintenance (and ~50% of the industry’s
value), China accounts for 2/3 of global new installations. Americas and Europe, where half the installed base is
over 20 years old, are more driven by Service volumes (maintenance and modernization), accounting for 60-80% of
value.
The
non-Asia NE market is 80-90% dominated by the “big 4” of Otis, Kone, Schindler and Thyssen, though they only
hold 45-50% of the China NE market. Otis is the market leader, with Kone a close second.
Otis (US-based, owned by UTC) is the largest E&E firm in the world; with the biggest installed base and biggest
mix of maintenance. Industry leading execution (and thus 10% higher margins) has made Otis the industry
innovator, being the first to globalize its supply base and pushed first into China. Otis lost market share in recent
years (which Kone gained) following a deadly accident in China, but has been recovering share in 2012-14 (VAR
Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside
Pavel Kaganas [email protected]
5
calls indicate it is no longer black-listed for gov’t work). Otis just completed a large restructuring program that
combined E&E with their other building services/materials (e.g. HVAC, security) into one selling and ops group.
Schindler (Swiss-based; public) is the largest player in escalators; has been pushing aggressively for global growth
and capacity increases (especially catching up to Otis and Kone in China.) Operational hiccups, expensive expansion
and delayed restructuring program have hurt margins. Schindler is most tied to Chinese infrastructure but is pushing
aggressively into residential. Essentially family run. Most likely to price down.
Thyssen (German-based; owned by ThyssenKrupp) is the most Americas-exposed, but has been pushing hard to
grow its small Asia base. It is also at the tail end of a large restructuring program.
Risks
China soft or artificial landing – China has been supporting its property and construction markets
extensively in recent years. It has more direct funding control over infrastructure and affordable housing,
but less over commercial residential markets (where Kone is most leveraged). Artificial support would
require large nationwide policy changes like loosening lending requirements, lowering down payment
requirements (30% on 1st mortgage, 60% on 2nd mortgages, 3rd homes are prohibited), or tightening rules
for moving capital outside of China. We have seen some of these desperation moves in 2Q14. However the
official China stance has been that even if it supports, it will try to avoid doing so for the housing market
for fear of oversupply and bubble development.
o The YTD decline in housing starts could also be the repeat of similar patterns in recent years
where a weak 1H was followed by a strong 2H; this is mitigated by more Chinese investments
moving abroad than in prior years.
Accretive Acquisitions – Kone admits to looking at large M&A opportunities (Europe & Asia competitors,
LatAm new entry), but not finding willing/reasonable sellers (conversation with IR). Considering the scale,
market share, and large European anti-trust settlement several years ago (~$1bn fines), a consolidation
seems unlikely. The Japanese OEMS are rarely sellers (and Kone is partnered with Hitachi.) Kone’s
relationships with real estate developers (and Otis’s recent operational consolidation of its E&E, security
Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside
Pavel Kaganas [email protected]
6
and HVAC services) might also guide Kone to make a large acquisition. Kone’s unlevered balance sheet
and cash flow would provide cheap borrowing cost and accretive terms.
Management
Kone has been well run (though usually chasing Otis’s strategy), first by the grandson of the founder (and still
Chairman) Antti Herlin from 1996-2006, then by Matti Alahuhta (previously at Nokia; still on Kone’s board), and
starting in 2014 by prior CFO Henrik Ehrnrooth (CFO 2009-13; previously Goldman Sachs investment banker).
The split-share structure retains the majority of the voting control with Chairman Antti Herlin, the head of one of
Finland’s wealthiest families. The Board announced a one-year repurchase program in early-2014 for up to 10% of
outstanding shares, but none have been repurchased YTD.
Valuation and Projections
Kone and other OEMs continue to guide for flat EMEA, slightly up Americas and ~10% China growth in 2014.
Though China’s 2012-13 construction starts (especially in housing) are unsustainable, the street still has an
overblown perception of Kone’s growth trajectory. This has been supported by results from its comps, all of whom
continue to report order growth in China. The street thus generally aligns with company lines, seen in consensus
EPS CAGR of 8%, from topline growth of 6% though 2014-15. 7 analysts have buy ratings, 9 holds and 8 sells
(mostly larger banks.)
The question of timing comes down to lead times: Chinese developers can delay Resi. E&E orders by 9 months
after a “start” (or longer by some analyst estimates), so orders may keep increasing through 2014, while starts and
sold footage continue to decline. This risk is offset by a weak European business, rich valuation and cheap carry.
The longer term upside of Chinese lead times
catching up into order declines will come from
the inevitable playing out of China’s over-built
housing inventory, E&E pricing pressure,
excess industry capacity, and over-earning
equipment margins. This construction
correction presents a more likely scenario of
declining revenue and margins, leading to 5%
EPS declines next two years.
The projections herein assume flattish EMEA
(though service margins continue to decline);
slightly up Americas; 0/15/10% down China
units and 1/2/4% China margin declines in
2014/5/6 (price pressure and cost absorption).
The declining earnings will alter the street’s
projections and re-value the shares that trade at
20x 2014 and 19x 2015 Consensus PE by
several turns. This will drop the shares to
~€20, giving ~40+% upside for a short at
current ~€32 levels. Kone shares are held
~10% short, pay a 3% yield, and trade
~€30mm daily volume on the Helsinki
exchange. Borrow is available.
(€mm) 2011 2012 2013 2014 2015 2016
EMEA 2,894 3,094 3,157 3,157 3,189 3,243
Americas 947 999 1,119 1,137 1,157 1,180
Asia-Pacific 1,384 2,184 2,657 2,803 2,456 2,274
NE Revenue 2,396 3,155 3,737 3,860 3,497 3,301
Service Revenue 2,829 3,122 3,196 3,237 3,304 3,396
Total Revenue 5,225 6,277 6,933 7,098 6,801 6,697
Total growth 5% 20% 10% 2% -4% -2%
NE EBIT 247 337 402 391 308 271
Services EBIT 478 486 552 550 548 554
Adjusted EBIT € 725 € 823 € 954 € 942 € 857 € 825
NE margin 10.3% 10.7% 10.7% 10.1% 8.8% 8.2%
Services margin 16.9% 15.6% 17.3% 17.0% 16.6% 16.3%
Total EBIT% 13.9% 13.1% 13.8% 13.3% 12.6% 12.3%
EBITDA € 791 € 909 € 1,033 € 1,020 € 935 € 903
margin 15.1% 14.5% 14.9% 14.4% 13.8% 13.5%
Net Income € 576 € 663 € 744 € 749 € 683 € 659
margin 11.0% 10.6% 10.7% 10.6% 10.0% 9.8%
EPS € 1.12 € 1.29 € 1.44 € 1.45 € 1.33 € 1.28
growth 15% 12% 1% -9% -4%
2012 2013 2014 2015 2016
Est. EBITDA 2 2 € 909 € 1,033 € 1,020 € 935 € 903
Consensus € 1,124 € 1,217 € 1,303
Est. EPS 2 2 € 1.29 € 1.44 € 1.45 € 1.33 € 1.28
Consensus € 1.55 € 1.69 € 1.82
Kone Oyj (HLSE:KNEBV) – SHORT Price €31.69; target €20; 40% upside
Pavel Kaganas [email protected]
7
Appendix: Select China stats from construction, housing, and E&E markets
Inventories rising; Yields shrinking Excess construction and thus E&E orders
Supply outpacing demand
Kone won artificial share; Otis is recovering China E&E market